Deutsche Bank’s Real-Time Stress Test

The Justice Department wants to fine Deutsche Bank fourteen billion dollars—far more than expected—for its role in underwriting and issuing risky residential-mortgage-backed securities.

Photograph by Krisztian Bocsi / Bloomberg via Getty

Deutsche Bank, already branded the world’s riskiest bank by the International Monetary Fund, is in more trouble than anybody thought. Yesterday, the Wall Street Journal and Bloomberg reported that the U.S. Justice Department wants to fine Deutsche Bank fourteen billion dollars for its role in underwriting and issuing risky residential-mortgage-backed securities (or R.M.B.S.) from 2005 to 2007. Fourteen billion sounds like a lot of money to me. It also sounds like plenty to Deutsche Bank, which was expecting a fine of between two and three billion.

To be clear: there is a zero-per-cent chance that Deutsche Bank will ever pay fourteen billion dollars in this case. The Justice Department knows this, as does Deutsche Bank, which has said that it won’t pay that amount. The settlement of fines between financial institutions and regulators is always a courtly dance. The state goes right, the bank goes left; eventually, they meet in the middle. But this first number, the Justice Department’s gambit, is of a different magnitude than many people had expected. Perhaps most significant for Deutsche Bank (and for the markets) is that fourteen billion dollars is also much more than the total of 5.5 billion euros that Deutsche Bank has set aside to pay for litigation costs this year. Precedent suggests that the bank may eventually have to pay a little less than half of what was demanded. Even if the fine does settle at that much lower level, the bank would be in the mire. The bank agreed to pay $1.9 billion in 2013 to settle separate mortgage-securities-fraud claims. Meanwhile, it has yet to pay for its other significant outstanding legal case, relating to “mirror trades” in Russia, in which around ten billion dollars were spirited out of Russia between 2011 and 2015, using simultaneous stock transactions in Moscow and London. John Cryan, who became C.E.O. of the bank last year, has said he wants to settle in the mirror-trades case before the end of 2016.

I wrote about Deutsche Bank’s Russian scandal for this magazine in August. Shortly after that article was published, Deutsche Bank’s Chief Financial Officer, Marcus Schenck, told investors in private meetings that he felt the bank had put aside enough for its pending legal settlements. According to a note taken at one such meeting, Schenck told investors that, in the case of the residential-mortgage-backed securities, “if we are treated the same as the American banks”—such as Goldman Sachs and J. P. Morgan—then Deutsche Bank was in a good position to respond to the pending fine. (Goldman Sachs paid $5.1 billon, and J. P. Morgan $3.2 billion, for similar offenses relating to different amounts of mortgage-backed securities.)

The potential settlement figure for the Russian case, Schenck admitted, was “most difficult to quantify.” If it emerged that, Deutsche Bank had in fact executed mirror trades with parties on the U.S. Sanctions list relating to Russia’s actions in Ukraine, then the fine could be large. (BNP Paribas was fined nearly nine billion dollars for breaking sanctions in 2014.) This outcome, Schenck told investors, would be “nicht lustig”: not funny.

Nobody’s laughing. If, after a Brobdingnagian fine for mortgage-backed securities, Deutsche Bank also faces a huge settlement for mirror trades, the bank may need to recapitalize with German government money. As I wrote in August, this prospect should frighten even those who derive pleasure from seeing the bank, and its freewheeling culture, effectively policed:

Since 2011, the Federal Reserve has performed a yearly “stress test” of U.S. lenders, assessing whether banks would have enough capital to withstand the shock of an economic downturn. Deutsche Bank failed the test in 2015, and failed again this June, when “broad and substantial weaknesses” were uncovered. Soon after the Federal Reserve’s latest report was released, the International Monetary Fund issued a dire warning. Deutsche Bank, it said, was not only “one of the most important net contributors to systemic risks in the global banking system”; it was also a contagious agent, because of heavy financial “spillover” between Deutsche Bank and other lenders and insurers. Any kind of failure at Deutsche Bank, the I.M.F. suggested, would be extremely bad news for everybody.

The markets have already reacted to news of the Justice Department’s intent. At the time of writing—5:42 A.M., Eastern Time—Deutsche Bank shares were down seven per cent on the London Stock Exchange, to 12.16 euros, slightly more than the bank's all-time low, which occurred after the Brexit vote. That left Deutsche Bank's market capitalization at 16.77 billion euros, or about $18.6 billion—$4.6 billion more than the proposed R.M.B.S. fine.